3.9 Budgets

Learning objectives

• Distinguish between a cost centre and a profit centre, with examples.

• Explain the roles of cost and profit centres in an organisation.

• Describe the main types of budget and the methods used to set them.

• Construct a budget in the standard layout from given data.

• Calculate variances and identify each one as favourable or adverse.

• Explain the possible causes of variances and how managers respond to them.

• Explain the importance of budgets and variances in decision-making, and their limitations.

Introduction

A budget is a financial plan for a future period, setting out the revenue a part of a business aims to earn and the costs it may spend. Budgets turn a business's objectives into figures that managers can act on, and comparing the plan with what actually happens shows where the business is on track and where it is not.

Every kind of organisation budgets: a sole trader planning the next quarter, a school deciding how to share its funding between departments, a government department, and an event organiser such as the Paris 2024 Olympic and Paralympic organising committee, which had to deliver two Games on a fixed date within a budget of about €4.5 billion.

Budgets link closely to the key concepts. A budget set before a period begins must respond to change in costs, prices and demand during it, as rapid inflation in 2022 showed many organisations. Honest budgeting is also a question of ethics: managers who pad their budgets or hide overspending mislead the people who rely on the figures. Budgets also support sustainability, because an organisation that plans and controls its spending is more likely to survive in the long term.

What a budget is

A budget is a plan expressed in money. It is set in advance for a stated period, usually a year divided into months or quarters, and it is agreed by the managers who will be responsible for meeting it. A sales budget sets out how much revenue a department aims to earn; an expenditure budget sets out how much it may spend on each type of cost.

The person responsible for a budget is its budget holder. In a supermarket chain, for example, each store manager is usually the budget holder for that store's sales and staff costs, while the head of IT holds the budget for computer systems across the chain. Giving each budget to one named manager makes it clear who must explain any difference between the plan and the result.

How a budget differs from a forecast

A budget and a forecast both look forward, but they answer different questions. A forecast predicts what is likely to happen, such as the sales a business can expect next year given market trends; sales forecasting and the cash flow forecast are examples. A budget is a target or limit that managers commit to: it says what the business intends to achieve and how much each part of it is allowed to spend.

Forecasts are inputs into budgets. A business first forecasts its sales, then uses that forecast to set its sales budget, and then sets production and expenditure budgets that match the planned sales. When the forecast is poor, the budget built on it is poor as well.

Cost centres and profit centres

Before a business can set budgets, it must decide which parts of the organisation will have their own. Most businesses divide themselves into units whose costs, and sometimes revenues, can be measured separately. These units are called cost centres and profit centres.

Typical cost centres are support functions such as human resources, IT, accounts, maintenance, research and development and customer service. A cost centre can also be a machine, a production line or a delivery fleet. Managers of cost centres are judged on how well they control their costs compared with budget, and on the quality of the service they give to the rest of the business.

A profit centre earns revenue as well as incurring costs. Each branch of a retail chain, each hotel in a hotel group, each restaurant in a franchise and each product line of a manufacturer can be a profit centre. Managers of profit centres are judged on the profit their unit makes, so they are responsible for revenue as well as costs.

The organisation chart of a hotel group shows how the two kinds of centre can sit side by side. Hotel A and Hotel B both earn revenue from guests, so their profits can be compared. Within each hotel, the rooms, the restaurant and the spa can be separate profit centres too. The HR, IT and maintenance teams in group services support every hotel but sell nothing to guests, so they are cost centres.

A profit centre can contain several cost centres. A supermarket branch is a profit centre, while its bakery, its delivery vans and its checkout staff may each be cost centres within it. A business can also change how it classifies a unit: some firms charge their internal IT or design teams to the departments that use them, which turns these teams into profit centres with internal revenue.

The roles of cost and profit centres

Cost and profit centres let managers see where money is earned and spent inside the business. A single figure for the whole company's profit hides the fact that some branches or products may be very profitable while others make losses. Measuring each centre separately gives managers several kinds of information and incentive.

• Control of costs. Each centre has its own budget, so overspending can be traced to the unit responsible and corrected quickly.

• Decision-making. Profit figures for each branch or product show which ones to expand, which to improve and which might be closed or sold. A cost figure for a support function shows whether it would be cheaper to outsource it.

• Accountability. A named manager is responsible for each centre's results, which supports accountability throughout the organisation.

• Motivation. Managers who control their own budget and can see their unit's results often feel more responsible and more motivated, and profit centre results can be linked to bonuses.

• Benchmarking. Similar centres can be compared with each other, such as the sales per square metre of two stores or the cost per patient of two hospital wards.

• Decentralisation. Centres allow head office to pass decisions to local managers while still monitoring them through the figures.

The link to decentralisation is especially strong. When a business grows, head office cannot make every decision. Making each branch or division a profit centre allows delegation of decisions about staffing, local promotion and stock to the managers who know local conditions, while head office keeps control by setting budgets and reviewing each centre's results.

Problems with cost and profit centres

Dividing a business into centres also brings problems. The most common is the allocation of overheads. Costs such as head office salaries, the company website or national advertising benefit every centre, so they must be shared out using a rule, such as each branch's share of sales or floor space. Different rules give different profit figures for each centre, and a branch can appear to make a loss only because of the way overheads were shared.

• Unfair comparisons. Centres face different local conditions: a store in a wealthy city centre and a store in a town with high unemployment cannot be judged on profit alone.

• Competition between centres. Managers may compete for resources or customers instead of cooperating, for example two branches of an estate agent chasing the same clients.

• Short-termism. A manager judged on this year's profit may cut training or maintenance, which improves the figures now but harms the business later.

• Cost and time. Collecting and reporting figures for every centre takes time and needs accounting systems.

• Pressure and stress. Managers held responsible for results they cannot fully control, such as a fall in demand caused by a recession, may become demotivated.

Evaluation: when do cost and profit centres work well?

Cost and profit centres are most useful in large organisations with many units that can be measured separately, such as retail chains, hotel groups, banks and manufacturers with several product lines. A small business with one shop gains little from them, because the owner already sees every cost and every sale.

Their value depends on how they are used. When overheads are shared by a clear and accepted rule, when managers are judged on the costs and revenues they can actually control, and when results are used to learn rather than to blame, centres improve control and motivation. When centre figures are used mechanically, for example to close every branch that shows a loss after a share of head office costs, they can lead to poor decisions. A branch that covers its own direct costs still makes a contribution towards the business's fixed costs, so closing it may reduce total profit.

Types of budget

A business usually sets several budgets that fit together. The most important is the sales budget, because the planned level of sales determines how much the business must produce, how many staff it needs and how much it can afford to spend.

The budgets depend on each other. If the sales budget is cut because demand weakens, the production budget, the materials budget and the staffing budget must all be cut too. This is why budget setting usually starts with sales and then works through the rest of the business.

Fixed and flexible budgets

A fixed budget is set for one planned level of output and is not changed when actual output differs. A flexible budget is adjusted, or flexed, to the level of output actually achieved. Flexing matters most for variable costs: if a restaurant serves 20% more meals than planned, it will also spend more on food, and comparing that spending with the original budget would wrongly suggest overspending.

Setting a budget

Budget setting follows a cycle that repeats every period. Senior managers set objectives; the finance team and budget holders forecast sales and costs; each budget holder drafts a budget; the drafts are coordinated and approved as a master budget; actual results are recorded and compared with the budget during the period; and the differences, called variances, are analysed so that managers can act and improve the next budget.

The cycle shows that a budget is not set once and forgotten. Monitoring actual results against the plan, usually monthly, is what turns a budget from a forecast into a tool of control. Many businesses also revise their budgets during the year when conditions change sharply; the Paris 2024 organising committee held five budget reviews in all.

Historical (incremental) budgeting

The most common method is to start from last period's budget or actual figures and adjust them for expected changes, such as inflation, planned growth or a new product. This is called historical or incremental budgeting.

Incremental budgeting is quick, simple and based on real data, so it suits stable businesses. Its weakness is that past waste is carried forward: a department that overspent last year starts from a higher base, and nobody asks whether each activity is still needed. It can also encourage managers to spend their whole budget before the year ends, so that next year's budget is not cut.

Zero-based budgeting

Zero-based budgeting starts every budget from zero. Each budget holder must justify every item of spending as if it were new, explaining what it achieves and why it is worth its cost. Spending is approved only when it supports the business's objectives.

Zero-based budgeting removes waste and makes managers think about why they spend money. It became well known when Kraft Heinz and other companies owned by the investment firm 3G Capital used it to cut costs sharply after mergers. Its disadvantages are the time and effort it takes, the risk that useful but hard-to-justify spending (training, research, brand building) is cut, and the pressure it puts on managers. Many businesses therefore use it every few years or for selected departments only.

Who sets the budget: top-down or participative

Budgets can be imposed from the top, with senior managers setting targets for each department, or built from the bottom up, with each budget holder proposing a budget that is then discussed and agreed. Imposed budgets are faster and keep spending in line with the business's strategy, but managers may see them as unrealistic and feel little commitment to them. Participative budgets use the knowledge of the people closest to the work and tend to motivate them, but they take longer and make budget padding more likely.

Constructing a budget

In the standard layout, a budget is a table with three figure columns: budgeted figures, actual figures and the variance. The rows are grouped into revenues and costs, each with its own total, and the last line shows the difference between total revenues and total costs. This final line is called "excess of revenues over (under) costs", which works for profit-making businesses and for non-profit organisations such as charities, clubs and schools.

The same table is used at two moments. Before the period begins, only the budgeted column is filled in: this is the budget itself. During and after the period, the actual figures are added and the variances calculated. The table then becomes a budget report, also called a variance report.

The standard layout of a budget for "ABC Ltd" (a profit-making business) or "ABC" (a non-profit organisation) has the same lines for both. [F] means favourable and [A] means adverse. The excess of revenues over costs was budgeted at $275 million but was only $266 million, because higher salaries and wages ($30 million over budget) outweighed the extra sales revenue.

Variances

Once a period has begun, managers compare actual results with the budget. The difference between the two for any line is a variance. Variances show which parts of the plan are working and which are not, and they are the starting point for asking why.

The size of a variance matters, but so does its direction. A variance is labelled favourable or adverse according to its effect on profit, or on the excess of revenues over costs, and not according to whether the actual figure is bigger or smaller than the budget.

A favourable variance means the business did better than planned on that line. If a shop budgets for sales of $40,000 and actually sells $43,000, the variance is $3,000 [F]. If it budgets $5,000 for electricity and spends $4,600, the variance is $400 [F].

An adverse variance means the business did worse than planned on that line. Adverse variances are sometimes called unfavourable variances. The same rules apply to every line of the budget, which the variance matrix summarises.

In a budget report the variance is usually written as a positive amount followed by [F] or [A], as in the standard layout. Using the formula, a revenue line with a budget of 500 and an actual figure of 520 gives 500 − 520 = −20; the minus sign shows that actual revenue exceeded the budget, which is favourable. A simpler method is to calculate the size of the difference and then decide the label by whether profit rose or fell.

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Variances for the totals are found in the same way as for each line. The variance on the final line can be checked by combining the total revenue and total cost variances: a favourable variance adds to the excess and an adverse one reduces it. If total revenues are 15 [F] and total costs are 24 [A], the excess of revenues over costs is 24 − 15 = 9 [A], as in the standard layout.

Variance analysis

Calculating variances is only the first step. Variance analysis is the process of investigating why each significant variance happened and deciding what to do about it. Managers concentrate on the largest variances and on those that keep recurring, an approach known as management by exception: lines that are close to budget need no action, so attention goes where it is needed.

Expressing a variance as a percentage of the budgeted figure helps managers judge whether it matters. In the workshop, the advertising variance of $600 [A] is small in dollars but 40% over budget, which suggests a real loss of control. The repair revenue variance of $2,300 [A] is larger in dollars but only about 4.3% of budgeted repair revenue.

Possible causes of variances

Variances arise because conditions differ from the assumptions on which the budget was based. Some causes are internal and within managers' control; others are external and are not. Identifying which applies is central to deciding the right response.

The cause matters more than the label. A materials variance caused by waste on the production line needs action inside the business, such as training or better quality control. A materials variance caused by a world price rise is outside managers' control, so the right response may be to look for other suppliers, raise prices or revise the budget.

Why favourable is not always good, and adverse not always bad

A favourable variance can hide a problem. A marketing department that spends less than its budget has a favourable variance, but if the cut in promotion causes sales to fall, the business is worse off overall. A production manager who buys cheaper, lower-quality materials gets a favourable materials variance but may cause more returns and complaints later.

An adverse variance can be a sign of success. If sales are much higher than planned, the costs of materials, packaging and delivery will also be higher, so those cost lines will show adverse variances. These are the result of extra business and are covered by extra revenue. Variances should therefore be read together, line by line, not one at a time.

Flexing the budget

A flexible budget solves the problem of comparing costs at different levels of output. Variable costs in the budget are recalculated for the actual level of output, so the comparison shows whether the business used resources efficiently, separately from the effect of selling more or less than planned.

Flexing shows that the original fixed budget hid a problem. This is why many businesses compare variable costs with a flexed budget and fixed costs, such as rent, with the original budget.

Budget reports are often given with some figures missing, and the gaps are found by working from the variances and the totals. The budget report of Riverside Swimming Club, a non-profit community club, has seven missing figures (hypothetical data).

The importance of budgets and variances in decision-making

Budgets and variance analysis are management tools. They help managers make decisions before a period begins (what to aim for and how to share resources), during it (where to act) and after it (what to change next time). Their main roles can be grouped into five.

Planning

Setting a budget makes managers think ahead about objectives, resources and risks. It turns broad aims, such as growing sales in a new region, into specific figures for revenue, staff and promotion. Planning also shows in advance when the business will need extra finance, so it can arrange a loan or overdraft before a problem arises.

Coordination

Budgets coordinate the different functions of a business. The sales budget tells the operations department how much to produce, the HR department how many staff to recruit and the finance department how much cash will be needed. Without this link, marketing could plan a campaign for a product that operations cannot make in time.

Control

Comparing actual results with the budget shows managers where performance differs from the plan. Variance analysis identifies problems early, before they become serious, and directs attention to the lines that need it. Control is the main reason budgets are reviewed monthly rather than only at the end of the year.

Motivation

A budget gives managers and their teams a clear target. When budget holders take part in setting a challenging but realistic budget, they are more likely to commit to it, and meeting it gives a sense of achievement and recognition. Budgets linked to bonuses can be a financial reward; the freedom to manage one's own budget is a form of empowerment.

Accountability and resource allocation

Each budget has a named holder who must explain variances, so budgets make managers accountable for the resources they use. Budgets also show senior managers where money is most productive, which helps them share limited funds between departments, projects and branches, and decide which activities to expand or cut.

Variance analysis feeds directly into decisions. Repeated favourable sales variances in one region may justify more investment there. A persistent adverse cost variance may lead managers to change supplier, retrain staff or raise prices. A variance caused by an external shock, such as a rise in energy prices, may show that the budget itself must be revised.

Limitations of budgets

Budgets have weaknesses, and these grow when budgets are used rigidly or treated as ends in themselves.

• Inflexibility. A budget set months in advance may become unrealistic when conditions change. Managers may refuse a profitable opportunity because it is "not in the budget", or keep spending on an activity that is no longer needed.

• Based on forecasts. Budgets are only as good as the forecasts behind them. Unexpected events, such as a sudden rise in inflation or a pandemic, can make every figure wrong.

• Time and cost. Preparing, negotiating and monitoring budgets takes managers' time, especially with zero-based budgeting.

• Budget padding. Budget holders may ask for more than they need, overstating costs or understating sales targets, so that they can meet the budget easily and look successful. Padding wastes resources and makes the budget less useful for control.

• "Spend it or lose it". Managers may spend any remaining budget before the year ends, often on things the business does not need, so that next year's budget is not cut.

• Demotivation. Budgets imposed from the top or set too tightly can demotivate staff, and blaming managers for variances they could not control damages trust.

• Short-termism. A manager focused on this year's budget may cut training, maintenance or research, which harms the business in the long run.

• Conflict. Departments may compete for a larger share of a fixed total, which can damage cooperation.

Budget padding and hiding variances also raise ethical questions. Deliberately misstating figures to make one's own performance look better misleads colleagues and owners, and in public bodies it misuses taxpayers' money.

Evaluation: how useful are budgets?

Budgets are among the most widely used management tools, because planning, coordination and control are needed by every organisation that spends money. Their usefulness depends on several factors.

• How stable the environment is. In stable markets, budgets based on past figures are accurate and useful. In fast-changing markets, budgets must be revised often or replaced by rolling forecasts.

• How the budget is set. Participative budgets based on realistic forecasts gain commitment; imposed or padded budgets do not.

• How variances are used. Variance analysis that looks for causes and learns from them improves performance. Using variances only to blame managers encourages padding and hiding problems.

• The size and type of organisation. Large organisations with many departments and budget holders gain most from formal budgets; a small business may need only a simple plan.

• Flexibility. Flexible budgets and regular revisions keep the budget relevant when output or prices change.

On balance, budgets are most valuable when they are used as a framework for decisions that can be revised. A business that sets realistic budgets with the people who must meet them, reviews variances regularly and is willing to revise the plan when conditions change gains the benefits of planning and control while limiting the costs of rigidity.

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Case study: the Paris 2024 organising committee's budget

The Paris 2024 Olympic and Paralympic Games were run by an organising committee, a private non-profit body responsible for staging the events: the ceremonies, the competition schedule, ticketing, temporary venues, technology, transport for athletes and thousands of staff and volunteers. Building permanent venues and infrastructure was handled separately by public bodies. The committee was financed mainly by private revenue: a contribution from the International Olympic Committee (IOC), sponsorship from domestic partners, and ticketing and hospitality. Public subsidies of €204.1 million, under 5% of its revenue, went entirely to the Paralympic Games.

An organising committee faces a demanding budgeting problem. It sets its budget about seven years before the event, its income depends on sponsorship deals and ticket sales that are not yet agreed, and the Games cannot be delayed if costs rise. The committee therefore revised its budget repeatedly, holding five budget reviews in all, the last of them after the Games.

The budget set in 2018 was €3.8 billion. The largest revision came at the third budget review in December 2022, when the board raised the multi-year budget by about 10%, from just under €4 billion to €4.38 billion. About half of that increase came from inflation, as rising energy prices after Russia's invasion of Ukraine pushed up the cost of energy, materials and services; the rest came from extra spending, including on security and the ceremonies. In January 2023 the Cour des comptes, France's public audit court, judged that the committee's budget balance was not yet secure and that uncertainty remained about its expected revenue, especially from partnership contracts.

At its final budget review on 12 December 2024, after the Games, the board adopted figures of €4,480.7 million of revenue and €4,453.9 million of expenditure, a surplus of at least €26.8 million.

Expenditure was about 17% above the original forecast. The committee stated that at least half of this increase came from inflation in 2022 and the rest from a wider scope, including an extra €100 million for security. On the revenue side, ticketing and hospitality brought in €1,489 million, €348 million above the bid target, with 12.1 million tickets sold, and domestic partnerships brought in €1,238 million, €150 million above target. A €43 million financial guarantee from public bodies was not needed.

The variance report shows how the committee stayed in balance. Its costs ran €653.9 million above the original budget, an adverse variance of about 17%, but its revenues ran €680.7 million above, a favourable variance of about 18%. The favourable revenue variances in ticketing and sponsorship offset the adverse cost variance. The original figures are approximate: they are derived from the reported amounts by which each line exceeded its bid target and from the reported increases of 17% in expenditure and 18% in revenue, which put both revenue and expenditure at about €3.8 billion at the bid stage.

Several ideas about budgets appear in the case. Repeated revisions show budgeting as a cycle: the committee updated its plan as forecasts of costs and revenues changed, instead of holding to a budget that was no longer realistic. The causes of the cost variance were partly external (inflation, the security situation) and partly decisions to widen the scope, which shows why variance analysis must look for causes and not only at the size of the numbers. Strong ticket sales were a favourable variance that depended on demand, which was itself uncertain when the budget was set.

The case also shows the limits of judging success by one budget. The committee's budget covered only the cost of staging the Games. In its 2025 report to Parliament, the Cour des comptes estimated public spending linked to the Games at €3.02 billion for their organisation and €3.63 billion for infrastructure, well beyond the committee's own budget. By then, the committee's final surplus was reported as €75.7 million. Whether the Games stayed "within budget" therefore depends on which budget is considered, and the surplus of one organisation says little about the total cost to taxpayers.

• Explain why the Paris 2024 organising committee needed to revise its budget several times before the Games.

• Using the variance report, explain how the committee ended with a surplus although its costs were about 17% above the original budget.

• Distinguish between the variances the committee could control and those it could not, using examples from the case.

Sources: Paris 2024 board statement on the final budget, reported by Sportcal (13 December 2024) and An Eventful Life (December 2024); Cour des comptes report on the organising committee, reported by Banque des Territoires (10 January 2023); Cour des comptes report to Parliament, reported by Defense-92 (1 October 2025).

Exam practice

The questions that follow use the June budget report of Café Lumière, a café in Lyon (hypothetical data).

Paper 3 questions on a social enterprise can also draw on budgets, because many social enterprises rely on grants and donations and must show funders how their money is spent.

Summary

• A budget is an agreed financial plan of revenues and costs for a future period, held by a named budget holder.

• A cost centre has costs attributed to it; a profit centre has both costs and revenues, so its profit can be measured.

• Cost and profit centres support control, decision-making, accountability, motivation and decentralisation, but overhead allocation can make comparisons unfair.

• Budgets can be set incrementally from past figures or from zero, and imposed from the top or agreed with budget holders.

• A variance is the difference between budgeted and actual figures: favourable if it raises profit, adverse if it reduces it.

• Variance analysis looks for the causes of significant variances, internal or external; flexing the budget gives a fairer comparison when output changes.

• Budgets help with planning, coordination, control and motivation, but can be inflexible, time-consuming and open to padding.

Self-check

• To do:

  I can define a budget and distinguish it from a forecast.

• To do:

  I can distinguish between a cost centre and a profit centre and give examples of each.

• To do:

  I can explain the roles of cost and profit centres, including their link to decentralisation.

• To do:

  I can describe incremental, zero-based, imposed and participative budgeting.

• To do:

  I can construct a budget in the standard layout and check every total.

• To do:

  I can calculate variances and label each one favourable [F] or adverse [A].

• To do:

  I can flex a budget and explain why a fixed budget can be misleading.

• To do:

  I can explain possible causes of variances and how managers might respond.

• To do:

  I can explain the importance of budgets and variances in decision-making and their limitations.